The Security Market enables an investor to invest in Equity and Debt.
Equity: Equity gives the investors a right to ownership in the company. The capital received by a company through issue of equity shares is permanent capital. Though investors can sell their shares and transfer ownership to another investor but the capital of the company remains untouched. The return on equity is varies and depends on price fluctuations of shares.
Debt: Company can raise funds through issue of Debt Securities. Debt is a form of loan that the company borrows from investors in exchange of fixed return on their investment. Debt is thus temporary capital and return on debt instrument is fixed at the time of issue.
Features of Equity Capital
- Nature: Equity capital is permanent capital that is provided by the owners/shareholders of the company. The profits or returns received by shareholders depends on the performance of the company. Investors that are interested in earning profits by taking calculated risk on the performance of the company opt for equity shares.
- Denomination: Equity capital is denominated in equity shares, with a face value. Face value in India is typically Re. 1, Rs. 2, Rs. 5 or Rs. 10 per share.
- Inside and outside Shareholders: Equity Capital can be provided by two types of shareholders. The first are the inside shareholders or promoters who start the company with their funds and entrepreneurial skills. These include large institutions with huge funds that they invest in early stages of the company and become inside shareholders. Outside shareholders include the general public that invest during later stages when the company has expanded.
- Part ownership: Equity shareholders are part owners of the company. This implies that their ownership is only limited to the number of shares they have invested in the company. For example, If a company issues 10,000 equity shares of face value Rs. 10 each, then its equity capital is worth Rs. 100,000 (10,000 multiplied by 10). If promoters own 5100 of the 10000 shares issued by a company, they are said to have a 51% stake, or a majority stake. If an investor holds 2000 shares of the 10000 shares issued (2% stake) then his ownership in the company is limited to 2%.
- Variable return and residual claim: Equity capital is permanent and it is not returned during the life of the business. Equity investors receive periodic returns in the form of dividend. The rate of dividend depends on the profitability of the business and the availability of surplus for paying dividends after meeting all costs, including interest on borrowings and tax. If the company were to shut down due to losses, all the proceeds from selling assets would be paid to other claimants such as government, lenders and employees, and any residual amount, if at all, is paid to equity shareholders. Thus equity shareholders are residual claimants.
- Net worth: Companies are not forced to distribute their profits in form of dividends every year they may retain these profits within the company, called retained earnings. This form part of company’s reserves. Reserves enhance the net worth of the company and equity shares in the market. Shareholders have a right to the company’s reserves when it is distributed eventually.
- Management and Control: Promoters of a business are the initial shareholders of a company. They may directly control the management of the company. When company seeks capital from the public ownership and management get separated, It is not feasible for thousands of shareholders holding a small proportion of capital each, to be involved in managing the company. Hence the shareholders appoint a group of people as the Board of Directors who will help in management of the company. Large shareholders with a significant shareholding may be represented in the board. Shareholders receive voting rights and several important decisions require shareholder approval expressed through their vote in a general meeting or through a postal ballot.
Investing in equity
The price of the equity share in the secondary markets, where it is listed and traded, primarily reflects the prospects of the business. A rise in price of shares of a company indicate increase in prospects or profitability. Movement in the share price can lead to profits/losses for the investor.
- Intrinsic value is the future value that the investor forecasts. Investors should consider intrinsic value while investing in shares.
- Intrinsic value is the estimated value per equity share, based on the future earning potential of a company. Investing in equity is about estimating this intrinsic value, and paying a price to earn the future value.
- Market price is the price at which the shares trades in the financial markets.
- This price is influenced by a number of factors. The process is tedious and inefficient and so prices may not always reflect the underlying intrinsic value of the share.
- When the intrinsic value is said to be more than the market price, the share is known to be undervalued and when the intrinsic value is less it is known to be overvalued.
- Undervalued shares should be invested in, since the market price is likely to reach its intrinsic value. Whereas the price of overvalued share is likely is fall down to its intrinsic level leading to losses.
- But it remains tough to make these evaluations correctly and consistently, as what is being priced is the unknown future of the company.
Equity investing process
- Security Selection: Shares of companies are available both in primary and secondary markets. Selection of market and shares for investing depends on understanding the business, future prospects, profit forecasts, expansion plans etc. These factors impact the future value of the stock.
- Market timing: All equity shares may not be attractive at all times. Thus a periodic check must be done on market conditions or factors that might influence the company. For example, in a slowing economy, steel and construction sectors may relatively slow down more than businesses into cooking oil and soaps. Thus the investment made in these shares must be liquidated. Similarly if a business is at its initial growth stage enjoying profits from its innovation and monopoly in market, shares in such companies can be purchased for their intrinsic value.
- Sector and segment weighting: The choice of which group of shares to invest in, i.e. large or small, new or established ,growth-oriented or dividend-paying stocks, determines how the equity portfolio may perform in terms of risk and return. Equity portfolio management includes choosing the right proportion of stocks from each sector in a way to maximise profits by defining underlying risks.
Equity Analysis and Valuation
There are two parts to evaluating a stock for investment
- Fundamental analysis: It is a study of “Financial statements” and information of a company to estimate the future returns from it. Financial statements include evaluating the revenue, expenses, assets, liabilities and other financial aspects of the company.This is useful in estimating the earning potential and hence the intrinsic value of the shares.
- Technical analysis: It involves studying the prices of stocks rather than its intrinsic value. Technical analysis is a study of historical prices and market trends. Technical analysis is concerned with past trading data and what information the data might provide about future price movements.
Equity analysis thus requires both fundamental and technical analysis of stocks since one contributes to understanding the financial aspects and true valuation along with profits of the company whereas the other evaluates the price trends and forecasts future prices for making investment decisions.
Information for equity analysis is gathered from the following sources:
- Audited financial statements
- Analyst meetings, plant visits and interactions with the management
- Industry reports, analytics and representations
- Government and regulatory publications
Commonly used terms in Equity Investing
Price earning multiple: The price earning ratio or multiple basically calculates what the market is willing to pay for a share of a company based on its current earnings.It is computed as:
Market price per share / Earnings per share: Earnings per share is the profit after taxes divided by the number of shares. It indicates the amount of profit that is available, for every share the company has issued. Eg. A stock is currently trading at 50Rs/- a share and its earnings per share for the year is 5Rs/-.
P/E ratio would be calculated like this: 50/5= 10, the price earning ratio of this stock is 10 times which means investors are willing to pay 10 rupees for every rupee of earning. As a company’s earnings per share being to rise, so does their market value per share. A company with a high P/E ratio usually indicated positive future performance and investors are willing to pay more for this company’s shares. A company with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could prove to be a poor investment.
Price to book value (PBV): The PBV ratio compares the market price of the stock with its book value. It is computed as market price per share divided by the book value per share. The book value is value of the share in the books of the company i.e value of a company’s assets expressed on the balance sheet. Since the assets in company books is shown at its cost minus the depreciation and are not inflation adjusted, true realizable value of assets cannot be determined from books. Thus when it is compared with current market price of assets we can know if a stock is undervalued or overvalued. Eg. If market price of the stock were lower than the book value and the PBV is less than one, the stock may be undervalued and vice versa.
Dividend yield ratio: The dividend declared by a company is a percentage of the face value of its shares. Eg. When the dividend received by an investor is compared to the market price of the share, it is called the dividend yield of the share.A 40% dividend declared by a company with face value Rs 10 of each share, the dividend amount is Rs 4 (10* 40%) on each share.
Calculation: Dividend yield ratio= Market price per share/ Dividend per share
therefore in the above example, if the market price of share was Rs 200, the dividend yield ratio would be 2% (200/10)
A security’s dividend yield can also be a sign of the stability of a company and often supports a firm’s share price. Normally, only profitable companies pay out dividends. Therefore, investors often view companies that have paid out significant dividends for an extended period of time as “safer” investments.
Risk and Return from investing in equity
Return: As we know the returns on equity investment are fluctuating and are received in periodic dividends and Increase in value of investment through change in share prices in secondary market. The equity market is highly volatile because large number of investors keep evaluating stocks and realigning their current investment position leading to fluctuating share prices. Since performance of companies can be evaluated based on its share prices, the company with increasing rate in share prices indicates profitability whereas deteriorating stock prices indicate an overall decrease in company share prices and profits.
Risk: The risk to an equity investor is that the future benefits are not assured or guaranteed, but have to be estimated based on dynamic changes in the business environment and profitability of the business.